DIY Smith Manoeuvre, Part 4
By Canadian Capitalist |
Investing · Smith Manoeuvre
Online only, 16/12/07
This is the fourth part in a series on implementing a do-it-yourself Smith Manoeuvre. You may also want to check out Part 1, Part 2 and Part 3 of the series.
Now that you are regularly withdrawing funds from the loan portion of your readvanceable mortgage and investing the proceeds in equities, there is only one step left: taxes. You should keep track of the interest paid on the investment loan, calculate the total interest expenses for the financial year and report it in Schedule 4 and Line 221 of your T1 General.
When your tax return is processed and a refund is issued, you should use the refund to pay down your mortgage and take out a loan and invest it to get the full benefit of the Smith Manoeuvre.
Notes:
I’ve said this before and I’ll say it again: Check with your accountant before implementing the SM. I’ve personally never borrowed money, invested it in index funds and claimed a tax deduction of the interest expense. So, check with your accountant or tax advisor.
Despite the complexity, SM is simply a leveraging strategy. As you may know, leverage cuts both ways. There is no guarantee that even over the very long term, equities will return more than the interest you pay on the loan. That’s the risk of implementing the SM. Don’t believe anyone who tells you otherwise.
In the interests of full disclosure, I have no intention of implementing the SM. I simply pay down the mortgage and am happy with guaranteed, risk-free, after-tax return of roughly 5%.
An adverse tax ruling is a risk with the SM and even if interest deductions are currently allowed, they may not be in the future. For example, in the 2004 Quebec budget, interest deduction was limited to the amount of interest income in that year.
With regards to the taxation side of leveraged investing, your rate of return will clearly depend upon the tax treatment for your investment. For me personally, I’ve borrowed cash from my HELOC to invest in a few junior REITs. My borrowed cash is a tax-deductible 6% and my junior REITs yield about 8-14% and they’re all 100% classified as return of capital (because depreciation and amortization bring the net earnings for these REITs close to zero)… So in reality it is a tax-deferred investment until some day in the distant future when it’s sold. But in the immediate tax year, for all intents and purposes, it is tax-free cash.
So, on a before-tax basis, my leveraged portfolio is returning about 6%, but after I file my taxes, it is like making 8% on that portfolio. The obvious risk to me is that if the investment implodes, then I’m on the hook for the huge hit to my portfolio. The other problem is if you have to sell the investment – such as what I did after the Halloween income trust massacre, I had to sell and realize a capital gain of some ridiculous 75% on one of my investments!
But then later on in the year, Coventree imploded (which I owned shares of), so I did some tax selling on that stock to offset my massive capital gains on that other junior REIT. What a topsy-turvy investment environment we’re in, all compounded by our punishing tax regime! But that’s what the Smith Manoeuvre is all about – manipulating our investments to squeeze the maximum tax efficiency out of everything.
Phil: Just to verify, are you repaying the loan with distributions from the REIT? If almost the entire amount is ROC and you still keep the loan, the deductions will be disallowed.
I occasionally borrow to invest (in the recent market turmoil, it was BMO and RioCan) but I do it sparsely (never exceeding 10% of our portfolios) and rarely (perhaps once every year). Still, leveraging is a tough game to play.
I haven’t seen any tax ruling which is that specific about what you can and can’t invest in… It only states that you have to invest for income and as far as I know, REITs qualify as income generating investments – I get a distribution every month. And yes, I use the cash distributions from the REIT to pay down the loan.
CC is right – if you get a dividend that is return of capital, that is the equivalent of selling some of the shares which means that the portion of the loan covering those shares is no longer tax deductible.
You have to either declare the interest on the portion of the loan that is still tax deductible or do what Phil is doing and pay down the loan by the amount of the ROC dividends.
Mike
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CC / FourPillars,
I searched CRA web site about tax deductibility of the interest on investment loan when the investment distributes ROC, but I couldn’t find any references. How /Where did you learn that ROC portion of the loan is not tax deductable?
Thanks,
A Y
Where is part 2???